An economist’s guide to business and consumer confidence

Consumer and business confidence indicators frequently make news headlines and are used in speeches by analysts prognosticating on the health of the economy. But what are these indicators ultimately based on, why do they attract such interest and what can our government realistically do to shore them up?

Confident of what, exactly?

When a business person is asked about her level of confidence in the economy (sometimes also termed “sentiment”), the questions posed are of such a generic nature she will most likely answer them on the level of gut feel. She will not perform arithmetic calculations to arrive at an exact value of sales over the last quarter – though she may make a passing judgement on the thickness of her order book, or recall phone conversations with clients over the past few weeks.

She will not sum up and formally compare the capacity of new suppliers coming into the market with the capacity of suppliers going out of business – though she may make a rough estimate of whether there seems to have been a recent expansion or contraction of her suppliers’ overall capacity. What she offers in response to a question about confidence is a ballpark overall expectation based on innumerable mini-observations of the level of activity of those whose behaviour he relies upon for his livelihood.

Similarly, a consumer’s confidence is built from 101 observations that he makes every day – from how much money is coming into his bank account, to whether his job seems secure, to whether the man next door is likely to get that promotion he has been hoping for.

Why the fuss?

One might think that the unincentivised guesses of a random collection of business people and consumers would be a poor input for economic policy. Yet the first reason forecasters look so keenly at confidence levels is that those being surveyed have no reason to lie systematically. The second reason is that confidence surveys tap into a source of information that is both critical to the workings of the economy, and untapped by any other aggregate economic indicator.

It may well be that some individuals respond with only noise to a confidence question: that is, their answers are not informed by any economic signals they have received. However, this noise will not be on average positive or negative as long as responders are neither materially nor psychologically rewarded for over- or under-estimates. When aggregated across a large number of survey respondents, the randomness of this noise means the noisy optimists should cancel out the noisy pessimists, taking them both out of the equation and leaving us with a roughly accurate measure of overall sentiment.

Second and more subtly, the type of information being captured in confidence questions is that same micro-level information we rely upon implicitly to keep the economy’s wheels turning smoothly every day.

One of the crowning achievements of capitalism is that micro-signals hard to observe at any higher level of aggregation are directly drawn upon in the small production and consumption decisions taken every day in our economy.

People make economic choices based on their likelihood of working out well, which is (correctly) perceived to be a function of surrounding market conditions, which we judge through our interpretation of micro-signals. This constant exploiting of micro-signals through individual micro-actions is astoundingly efficient, and a key reason for capitalism’s superiority as an economic system to communism: in the latter, these micro-signals are unobserved and as a result not acted upon by the central authority that determines production levels.

A capitalist system by contrast relies upon each individual doing what is best for him personally, which in turn means he rationally acts on those same innumerable micro-signals of activity, preference, and opportunity that inform his answers to confidence survey questions. Asking someone to answer those questions therefore constitutes an attempt to harness the lifeblood of economic decision making.

Priming the pump

Armed with this understanding, what can a government do to respond to ailing measures of consumer or business confidence?

Because confidence on both sides of the market is built on signals of present potential and future opportunity, the most direct way for a government to shore up confidence is to increase the number or strength of signals that make opportunities appear plentiful and promising. One very direct way to do this is through infusing everyone’s bank accounts with cash. This type of Keynesian stimulus works because it makes everyone feel freer to pursue new opportunities and try out new products: everyone’s opportunity set has expanded.

Another, less trumpeted way for a well-meaning government to intervene when confidence is low is to act as an economic “matchmaker”. Pessimistic expectations are not the result of having tried out every possible trading partner in every existing market and having been turned down every time, but rather the result of some searching and experimentation that is limited by transaction costs.

If the government can help a supplier reduce transaction costs by encouraging market clearing mechanisms or fostering business forums and exhibitions, networking forums, and job fairs, then it can lift the spirits of the most hardened traders.

When it comes to predicting where the economy is headed, gut-feel confidence matters. The good news for governments is that because it’s based on signals that can be somewhat manipulated, confidence itself is more manipulable than one might think.

This article is published in collaboration with The Conversation. Read the original article.

Publication does not imply endorsement of views by the World Economic Forum.

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Author: Gigi Foster is an Associate professor at UNSW Australia Business School.

Image: A man walks past buildings at the central business district of Singapore. REUTERS/Nicky Loh